Tax Considerations for Contingent Interest and Convertible Debt in Cross-Border Lending Transactions

The treatment of contingent interest and convertible debt in cross-border payment transactions is subject to several provisions of the Internal Revenue Code.[1] To add confusion to the already complicated subject, the definitions of “contingent interest” or “contingent payments” have several different meanings:

1) There are tax rules dealing with Contingent Payment Debt Instruments (CPDI), which are a type of debt instruments that were singled out for special tax treatment within the regulations dealing with timing and character of instruments with original issue discount. The rules apply to certain debt instruments that provide for “contingent payments;”

2) there is a reference to “contingent interest” in the context of portfolio interest exemption from U.S. tax on foreign lenders under §§871 and 881 of the code;

3) there are references to “contingent interest” in the Treas. Reg. §1.897-1 dealing with taxation of foreign persons investing in U.S. real property interests;

4) most of the modern U.S. tax treaties contain provisions dealing with contingent interest payments.

This article examines each definition and the consequences of falling into each provision, with a focus on the tax consequences for foreign holders of debt instruments issued by U.S. debtors.

General CPDI Rules

The original issue discount rules in §§163(e), and 1271-1275 focus on ensuring that the income generated by debt instrument is properly accounted for and taxed, and on minimizing the mismatch between the character and timing of the deduction for the issuer and the corresponding inclusion for the holder of the debt instrument. Section 1275(d) grants the secretary of the treasury regulatory authority to prescribe regulations where, by reason of contingent payments, the tax treatment under the original discount rules does not fulfill congressional intention.

The CPDI regulations apply to debt instruments that 1) provide for one or more contingent payments, and 2) are not excluded from CPDI definition under the applicable Treasury Regulations.[2] The term “contingent payment” is not defined, but it is generally understood as either 1) payments that are contingent in amount, or 2) payments that are fixed in amount but whose timing is contingent. The regulations apply to debt instruments with contingent principal payments and contingent interest payments, and they generally do not distinguish between the two.

In general, if a CPDI is issued for cash or publicly traded property, the noncontingent bond method applies to the instrument.[3] Under the noncontingent bond method, interest accrues based on the comparable yield, which generally is the rate at which the debtors could issue a fixed rate debt instrument with terms and conditions similar to those of the applicable CPDI.

Several contingencies are explicitly excluded from the definition of contingent payment for purposes of qualifying the debt instrument as CPDI:

1) Default Risk: The risk of insolvency or default does not make a payment contingent.

2) Remote and Incidental Contingencies: A payment is not a contingent payment merely because of a contingency that, as of the issue date, is either remote or incidental. A “remote contingency” is defined by a reference to a remote likelihood that either the contingency will occur not occur. Some commentators state that a 5% probability of occurrence is a common benchmark used for determining whether a contingency is remote. Multiple remote contingencies may be combined, and if there is a non-remote likelihood that at least one of the contingencies will occur, none of the contingencies would be treated as remote. An incidental contingency is a contingency 1) relating to the amount of a payment if the potential amount of the payment is insignificant relative to the total expected amount of the remaining payments on the debt instrument, or 2) relating to timing if the potential difference in the timing of the payment is insignificant, in each case under all reasonably expected market conditions.

Additionally, certain debt instruments with contingent payments are excluded from CPDI rules, and are governed by separate rules:

1) Floating Rate: Variable-rate debt instruments (VRDIs) have contingent payments but are governed by separate VRDI regulations.[4] VRDIs are debt instruments where interest is tied to one or more qualified floating rates (QFRs), or at a single fixed rate and one or more QFRs. For example, an interest rate of SOFR + 2% is a QFR, while an interest rate tied to the value of S&P 500 index, value of some stock or other property, or based on the issuer’s profit is not a QFR.

2) Foreign Currency Debt: Treas. Reg. §1.988-6 provides that a nonfunctional currency borrowing is not considered contingent merely because it is denominated in a single, nonfunctional currency (even though payments would not be fixed in the functional currency).

3) Alternate Payment Schedule: Treas. Reg. §1.1272-1(c) applies to debt instruments that provide for alternative payment schedules applicable upon the occurrence of a contingency (or contingencies), but only if the timing and amounts of the payments that comprise each payment schedule are known as of the issue date and the debt instrument satisfies certain other conditions described in the regulations.

4) Fixed-Yield Debt: Treas. Reg. §1.1272-1(d) excludes from the definition of CPDI a debt instrument that provides for one or more contingent payments, but all possible payment schedules under the terms of the instrument result in the same fixed yield.

5) Inflation-Indexed Debt: Treas. Reg. §1.1275-7 provides separate rules for inflation-indexed debt instruments, which are defined as instruments with payments indexed for inflation or deflation.

6) Certain Other Exceptions: Various provisions of the code and Treas. Reg., exempt from CPDI rules are U.S. savings bonds, short-term taxable obligations, certain loans between natural persons, certain state-sponsored prepaid tuition plans, REMIC regular interests, certain other debt instruments subject to prepayment contingencies, and debt instruments with an issue price determined under I.R.C. §1273(b)(4) (i.e., installment sale obligations).

Convertible Debt with Contingent Interest Under CPDI Rules

Under the CPDI regulations, a convertible debt instrument does not provide for contingent payments merely because it provides for an option to convert the instrument into the stock of the issuer, into the stock or debt of a related party, or into cash or other property in an amount equal to the approximate value of such stock or debt. However, this exception for convertible debt does not apply when the debt instrument provides for contingent payments other than the conversion feature and those contingent payments are neither remote nor incidental. Although a conversion feature alone does not cause a convertible debt instrument to be CPDI, the possibility of a conversion is, nevertheless, a contingency if the instrument otherwise is treated as a CPDI regardless of the conversion feature.[5] Therefore, the comparable yield for a convertible debt instrument subject to the noncontingent bond method is determined under Treas. Reg. §1.1275-4(b) by reference to comparable fixed-rate nonconvertible debt instruments. Moreover, the projected payment schedule is determined by treating the stock received upon a conversion of the debt instrument as a contingent payment.

U.S. Tax Consequences for Foreign Holders of CPDI

If the debt instrument is CPDI, then, under the noncontingent bond method, each holder should be required to take into account interest based on the comparable yield, which generally is the rate at which the debtors could issue a fixed rate debt instrument with terms and conditions similar to the applicable CPDI debt.

If during any taxable year, the actual payments with respect to any CPDIs exceed the projected payments for that taxable year, the holders should incur a net positive adjustment”under the contingent debt regulations equal to the amount of such excess. In general, a net positive adjustment is treated as interest and is includible in income by the holder and deductible by the issuer in the taxable year in which the adjustment occurs.[6]

If during any taxable year, the actual payments with respect to any CPDIs are less than the projected payments for that taxable year, the holders should incur a net negative adjustment under the contingent debt regulations equal to the amount of such deficit. In general, a net negative adjustment: 1) reduces interest accruals on the debt instrument for the taxable year; 2) to the extent of any excess, is treated as an ordinary loss by a holder and ordinary income by the issuer, but only to the extent of prior accruals on the debt instrument by the holder or issuer; and 3) to the extent of any further excess, is a carryforward to the next taxable year.[7]

In addition, the general character rules applicable to debt instruments held as capital assets are replaced in the case of CPDIs with a special rule that treats all gain (whether from disposition of the instrument or from a contingent payment in excess of the amount projected) as ordinary, rather than capital, in character (except if at the time of the sale there are no remaining contingent payments due).[8]

Conversion event is taxed under CPDI rules. If on conversion the value of the underlying stock is greater than the stock’s projected value on the issuer’s projected payment schedule, then under the CPDI rules the amount of such excess will constitute a net positive adjustment that, as described above, gives rise to additional interest income to the holder and an additional interest expense to the issuer. If, instead, on conversion the value of the underlying stock is less than the stock’s projected value on the issuer’s projected payment schedule, then under the CPDI rules the amount of such shortfall will constitute a net negative adjustment subject to the rules described above.

Although foreign holders are subject to the same CPDI rules, the interest payment may qualify for portfolio interest exemption from U.S. taxation and withholding (as described below). If the foreign holder does not qualify for portfolio interest exemption, then CPDI rules disadvantage the foreign holder by subjecting the entire return on the debt to U.S. taxation and withholding, including the portion that would otherwise have qualified as exempt capital gain.

General Portfolio Interest Rules

As a general rule, non-resident aliens and foreign corporation are subject to a withholding tax on U.S.-source interest income that is not effectively connected with the conduct of a trade or business within the U.S.[9] The interest income is subject to withholding on the gross amount of the payment at the rate of 30%, unless reduced by an applicable income tax treaty. Under one of the exceptions to the general rule, interest payment to a foreign holder qualifies for an exemption from U.S. taxation and withholding under the portfolio interest exemption, provided that the following requirements are satisfied:

1) The foreign holder does not, actually or constructively,[10] own 10% or more of the combined voting power of all classes of issuer’s stock entitled to vote (or 10% or more of the capital or profits interest in the issuer that is a partnership); [11]

2) the foreign holder is not a controlled foreign corporation related to the issuer, directly or indirectly, through stock ownership;

3) the foreign holder is not a bank that acquired the note in consideration for an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business;

4) the foreign holder provides to the withholding agent or an intermediary the applicable withholding certificates and other documentation; and

5) the payment is made on an obligation that is in registered form.

Furthermore, portfolio interest does not include certain contingent interest. The definition of “contingent interest” under the portfolio interest rules is different than the definition of “contingent payment” under the CPDI rules, and it focuses on identifying interest payments that resemble returns on equity. Under the portfolio interest rules, “contingent interest” is defined as any interest if the amount of such interest is determined by reference to: 1) any receipts, sales or other cash flow of the issuer or a related person; 2) any income or profits of the issuer or a related person; 3) any change in value of any property of the issuer or a related person; or 4) any dividend, partnership distributions, or similar payments made by the issuer or a related person.

For example, a contingent interest that is tied to the value of the issuer’s property would be treated as contingent payment under CPDI rules and contingent interest under portfolio interest rules. However, contingent interest that is tied to the value of the publicly traded stock or debt of the issuer (or to the value of S&P 500 index) would be contingent payment under CPDI rules, but not contingent interest under portfolio interest rules.

The portfolio interest exception from the general withholding rules contains an exclusion for contingent interest. But, Congress would not be doing its job unless it enacted a series of “exceptions from the exclusion from the exception,” and it certainly did it in this case. Contingent interest exclusion does not apply to:

1) any amount of interest solely by reason of the fact that the timing of any interest or principal payment is subject to a contingency;[12]

2) any amount of interest solely by reason of the fact that the interest is paid with respect to nonrecourse or limited recourse indebtedness;

3) any amount of interest all or substantially all of which is determined by reference to any other amount of interest that is not contingent interest (or by reference to the principal amount of indebtedness on which such other interest is paid);

4) any amount of interest solely by reason of the fact that the debtor or a related person enters into a hedging transaction to manage the risk of interest rate or currency fluctuations with respect to such interest; or

5) any amount of interest determined by reference to certain actively traded property, the yield on such actively traded property, or changes in any index of the value of such actively traded property or its yield.[13]

Convertible Debt Under Portfolio Interest Rules

Convertible debt is not disqualified from the portfolio interest exemption merely because of its conversion option. However, convertible debt creates additional hurdles for portfolio interest exemption because it is treated as constructive ownership of the stock into which it is convertible. Accordingly, if the holder of the convertible debt holds more than 10% of the voting stock of the issuer (treating the conversion right as exercised), then the interest on the convertible debt will not qualify for the portfolio interest exemption.[14]

U.S. Tax Consequences for Foreign Holders of Debt with Contingent Interest Under Portfolio Interest Rules

Debt investments by foreign lenders are typically structured to qualify for the portfolio interest exemption, in which case the interest and capital gains are exempt from U.S. taxation and withholding.

If, however, the debt instrument does not qualify for the portfolio interest exemption (for example, because it provides for contingent interest under the portfolio interest rules or holder is treated as holding more than 10% of the vote), then the interest payments are subject to U.S. taxation and withholding at a 30% rate (or a reduced tax treaty rate, if applicable).

If the debt instrument does not qualify for the portfolio interest exemption and also meets the definition of CPDI, then the entire return on the debt instrument would be subject to U.S. taxation and withholding, including the portion that would otherwise have qualified as exempt capital gain.

General FIRPTA Rules for Debt

Section 897 of the code (along with other related sections, commonly referred to as FIRPTA) provides that gain or loss of a foreign person from the disposition of a U.S. real property interest is treated as effectively connected with such foreign person’s U.S. trade or business, and, thus, is subject to taxation and withholding at a rate of 15% (or 21% in some cases).

U.S. real property interest is defined, among other things, as any interest (other than an interest solely as a creditor) in any domestic corporation, unless such corporation establishes that it is not a U.S. real property holding corporation (a defined term, that generally refers to corporations with assets consisting primarily of U.S. real estate).[15] Treas. Reg. §1.897-1 elaborates that “interest solely as a creditor” does not include debt instrument with right to a payment that is contingent on “any direct or indirect right to share in the appreciation in the value, or in the gross or net proceeds or profits generated by, the real property.” Thus, for example, loans with shared appreciation rights or equity kickers are treated as contingent interest for purposes of FIRPTA rules.

Convertible Debt Under FIRPTA Rules

Convertible debt is also not treated as an interest solely as a creditor for purposes of exempting it from the FIRPTA rules. Accordingly, if the issuer is a U.S. real property holding corporation (assets consist primarily of U.S. real property), or a partnership that holds U.S. real estate, gains from the sale or exchange of the convertible debt may be subject to U.S. taxation and withholding. The interest payments on the convertible debt would not be subject to FIRPTA taxation and withholding, as long as they qualify for portfolio interest exemption described above.

There are special rules that apply to regularly traded convertible debt instruments and convertible debt instruments that are convertible into “regularly traded” equity. Regularly traded convertible debt instrument is treated as U.S. real property interests if the investor held more than 5% of the fair market value of such class of debt instruments at any time during the five-year period ending on the disposition date.[16] Non-regularly traded convertible debt instrument that is convertible into regularly traded equity interest is treated as U.S. real property interest only if on the date it was acquired it had a fair market value greater than the fair market value on that date of 5% of the regularly traded class of equity into which it was convertible.[17]

U.S. Tax Consequences for Foreign Holders of Debt Subject to FIRPTA

If the debt instrument does not qualify as an interest solely as a creditor (either because of contingent interest under the FIRPTA rules or because of an option to convert into equity), and the issuer is a U.S. real property holding company, or a partnership that holds U.S. real estate, then the debt instrument will be subject to FIRPTA rules.[18] Interest and principal payments on such debt instrument would not be subject to taxation or withholding under the FIRPTA rules (assuming that the interest qualifies for portfolio interest exemption). However, gains on sales or exchanges of such debt instruments would be subject to taxation and withholding under the FIRPTA rules.

U.S. Tax Treaties

Under the 2006 and 2016 U.S. model tax treaties, contingent interest arising in the U.S. is defined by reference to the interest that does not qualify as portfolio interest under the rules of §871(h). Such contingent interest is generally subject to U.S. withholding at the same rate as the highest withholding rate for dividends under the treaty (15% in the model treaties). The treaties generally do not treat convertible debt as providing for contingent interest, so long as the interest payments themselves are not contingent on the profitability of the issuer.

This approach is followed by many modern U.S. tax treaties, but there are significant variations and each individual treaty needs to be reviewed in detail. Some of the older treaties do not contain express provisions dealing with contingent interest. For example, the tax treaty with Mexico does not contain a provision on contingent interest, and such contingent interest should be subject to the same rules as the rules for fixed interest payments.

The U.S. tax treaty with Chile was signed in 2010, but due to delays in congressional approval, it entered into force on December 19, 2023. With respect to interest payments, the tax treaty with Chile generally provides that for the first five years, a maximum 15% withholding rate will apply, and after five years, a maximum 10% withholding rate will apply.[19] A lower 4% withholding rate may apply for interest paid to certain financial organizations or enterprises that sell machinery or equipment on credit. The tax treaty with Chile contains a definition of contingent interest that parallels the definition in the portfolio interest exception of §871(h)(4),[20] but it does not contain an explicit reference to the portfolio interest rules included in the 2006 and 2016 U.S. model tax treaties. Thus, it is not clear whether the treaty incorporates by reference all of the exceptions from the contingent interest definition that are contained in §871(h)(4)(c).

For example, if a Chilean bank loans money in the ordinary course of business to a U.S. borrower, and the loan has contingent interest that is determined by reference to changes in the value of actively traded property, such interest would not qualify for the portfolio interest exemption because the lender is a bank. In the absence of treaty benefits, the interest payments would be subject to a 30% withholding rate. The tax treaty reduces this withholding rate, but it is not entirely clear whether the applicable withholding rate should be 15% that applies to contingent interest, or 4% that applies to loans from banks. Although the text of the tax treaty does not expressly provide for an exception for contingent interest that is determined by reference to changes in value of actively traded property, one can argue that such exception was intended because the treaty was signed in 2010 and entered into force in 2023, and the 2006 and 2016 U.S. model tax treaties provide that this actively traded property exception would be applicable to contingent interest definition in the treaties.[21]

Conclusion

The preceding discussion illustrates the complexity of navigating the multitude of different rules that apply to contingent and convertible debt instruments. Moreover, the discussion above assumes that the interest qualifies as debt under the general U.S. federal income tax principles, but the distinction between debt and equity does not have a bright-line test. Debt instruments that have many contingent features are subject to additional risk of being reclassified as equity of the issuer.

*This was republished with permission from the Florida Bar. Click to access the publication.

[1] References to the “Internal Revenue Code” and the “code” are to the Internal Revenue Code of 1986, as amended.
[2] See, generally, Treas. Reg. §1.1275-4.
[3] See Treas. Reg. §1.1275-4(b). A different set of rules applies to non-publicly traded CPDIs that are issued in exchange for non-publicly traded property (other than cash). Under the cash method CPDI rules, the holder is required to bifurcate the debt instrument between its fixed and contingent components. The fixed components are accounted for under normal tax principles. The contingent components are accounted for using open transaction (i.e., wait-and-see) principles.
[4] See Treas. Reg. §1.1275-2(a)(2)(ii).
[5] See Rev. Rul. 2002-31. This ruling discussed a contingent interest convertible bond with a 20-year term that was issued for $625 and had a $1,000 face amount. Except for the contingent interest feature, the bond was a zero-coupon obligation. The bond was convertible at any time into a fixed number of shares of issuer stock having a value, on the issue date, that was significantly less than $625. Upon the third anniversary of its issue date, the bond could begin to pay contingent interest semi-annually, if the average market price of the bond over an applicable measurement period was greater than 120% of the bond’s “accreted value.” The amount of contingent interest payable in respect of the relevant semiannual period would be the greater of: 1) the regular cash dividend per share payable over that semi-annual period multiplied by the number of shares into which the bond was convertible; or 2) a specified percentage of the average market price of the instrument for the measurement period.
[6] Deductibility of issuer’s interest expenses, however, may be limited by other applicable rules.
[7] See Treas. Reg. §1.1275-4(b)(6).
[8] See Treas. Reg. §§1.1275-4(b)(6)(ii) and 1.1275-4(b)(8).
[9] Sections 871(a) and 881(a). Interest income that is treated as effectively connected with the conduct of a trade or business in the U.S. is subject to net income taxation at graduated income tax rates, and in some instances, may be subject to withholding under §1445 (for income connect with investments in U.S. real property) or under §1446 (for partnership income that is allocable to foreign partners).
[10] Section 871(h)(3)(C) of the code applies §318 constructive ownership rules, with certain modifications.
[11] There are legislative proposals that could change this to 10% of the vote or value of the issuer.
[12] For example, prepayment or deferral of the payment is not a contingency for purposes of the portfolio interest exception.
[13] See §871(h)(4)(C).
[14] The status of the foreign partners of a partnership as 10% shareholders is determined at the partner level. Accordingly, even if a fund taxable as a partnership holds convertible debt representing 10% or more of the total voting power of a corporate portfolio company on an as-converted basis, the foreign partners may still claim the portfolio interest exemption so long as their attributive share of the voting power is below 10%.
[15] As a cautionary note, the status of U.S. real property holding corporation may arise unexpectedly even for companies that are not in traditional real estate business. For example, companies in financial distress may find that the real estate assets comprise the majority of their value.
[16] See Treas. Reg. §1.897-1(c)(2)(iii)(A).
[17] See Treas. Reg. §1.897-9T(b).
[18] There is an additional exception available for publicly-traded instruments if the holder owns less than 5%.
[19] The effective date of the Chile treaty for withholding taxes is February 1, 2024, and, accordingly, the 15% withholding rate on interest payments applies until January 30, 2029.
[20] The treaty defines contingent interest as interest determined with reference to receipts, sales, income, profits, or other cash flows of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution, or similar payment made by the debtor or a related person.
[21] See 2006 U.S. Model Technical Explanation for art. 11, ¶2.